The Tax Cost of Hot Assets upon the Disposition of a Partnership Interest

TAX CLINIC

by
Angelina Milo, CPA, Cohen & Company, Akron, OH

Published August 01, 2010

Partners & Partnerships

Often a partner will negotiate a deal to dispose of his partnership interest without considering the tax implications of hot assets or how to best structure the transaction (as a sale or a redemption). This is because most are unaware that a disposition of a partner’s interest in an entity that holds hot assets may convert long-term capital gain to ordinary income or in certain cases may force the partner to recognize ordinary income offset by a nonutilizable capital loss upon the disposition.

Example 1: Partner A owns a 50% interest in ABC Partnership. ABC holds hot assets, otherwise referred to as Sec. 751 property or ordinary income property. A’s outside basis of his interest in ABC is $100,000. He sells his interest for $200,000, resulting in an overall gain of $100,000. The partnership assets consist of a Sec. 751 asset with a value of $400,000 and a basis of zero and a non–Sec. 751 asset with a value of zero and a basis of $200,000.

Since the partnership holds a hot asset, A is treated as having separately sold his 50% share of the Sec. 751 asset for its value of $200,000 ($400,000 × 50%) and will realize $200,000 in ordinary income. The remaining proceeds (zero) are then applied to the remaining basis of $100,000 ($200,000 × 50%), producing a $100,000 capital loss. In this case, rather than recognizing $15,000 in tax on $100,000 of long-term capital gain ($100,000 × 15%), A will incur an immediate tax liability of $70,000 ($200,000 ordinary income × 35%) and a tax benefit of $15,000 ($100,000 × 15%) at the time the capital loss is utilized. The net tax cost of the disposition of A’s partnership interest is $55,000 rather than $15,000. In this example, the application of Sec. 751 is important, given the 20% difference in tax rates between ordinary income and long-term capital gain, which is likely to continue to exist after 2010.

In the case of a sale or exchange, Regs. Sec. 1.751-1(a)(1) provides that

To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or . . . inventory items, the money or fair market value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under section 741.

In the case of a redemption, Regs. Sec. 1.751-1(b)(1) provides that

Certain distributions to which section 751(b) applies are treated in part as sales or exchanges of property between the partnership and the distributee partner, and not as distributions to which sections 731 through 736 apply. . . . Section 751(b) applies whether or not the distribution is in liquidation of the distributee partner’s entire interest in the partnership. However, section 751(b) applies only to the extent that a partner either receives section 751 property in exchange for his relinquishing any part of his interest in other property, or receives other property in exchange for his relinquishing any part of his interest in section 751 property.

As noted above, there are two categories of hot assets that trigger ordinary income upon the disposition of a partner’s interest: unrealized receivables and inventory items. Sec. 751(c) provides the definition of unrealized receivables, while Sec. 751(d) defines inventory items.

There are three categories of unrealized receivables: goods, services, and recapture items. Sec. 751(c) defines the term “unrealized receivables,” which include, “to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2) services rendered, or to be rendered.” For example, accounts receivables of a cash-basis partnership would be classified as an unrealized receivable.

The third category of unrealized receivables includes the following list of partnership assets, which, if sold by the partnership, may result in ordinary income recapture:

Sec. 1245 property;

Sec. 1250 property;

Understated rent—Sec. 467(c);

Farmland and land clearance deductions—Sec. 1252;

Oil, gas, and geothermal property—Sec. 1254;

Mining property—Secs. 617(d) and (f);

Franchises, trademarks, and trade names—Sec. 1253(a);

Market discount bonds—Secs. 1276(a) and 1278;

Short-term obligations—Secs. 1271(a) and 1283;

DISC stock—Sec. 995(c); and

Stock of a controlled foreign corporation—Sec. 1248(a).

Because Regs. Sec. 1.751-1(c)(5) provides that the basis of any potential gain recapture is zero, the recapture must be computed separately for each asset, assuming the asset has a zero basis. This may result in a partner’s recognizing ordinary income on the disposition of his or her partnership interest, although the aggregate fair market value (FMV) of all recapture properties would produce an overall loss if grouped in aggregate. The most common unrealized receivable recapture item that partners often overlook is partnership property subject to depreciation recapture under Sec. 1245.

Example 2:ABC holds a machine that it purchased for $400,000. ABC has claimed depreciation of $100,000, and the machine’s FMV is $410,000 at the time A disposes of his interest.

The partnership is treated as holding a hot asset with a basis of zero and an FMV of $100,000 and a non–Sec. 751 asset with a basis of $300,000 and an FMV of $310,000. Assuming that A sells his 50% interest in the partnership for $205,000 and his outside basis is $150,000, he would realize a $55,000 gain, of which $50,000 ($100,000 recapture × 50%) will be classified as ordinary income and $5,000 ($10,000 gain on non–Sec. 751 asset × 50%) will be classified as capital gain.

The regulations do not limit the definition of inventory items to items held primarily for sale to customers in the ordinary course of a trade or business, but they provide for a very broad definition to include realized and unrealized accounts receivables. Sec. 751(d) defines “inventory items” to mean

(1) property of the partnership of the kind described in Sec. 1221(a)(1), (2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in Sec. 1231, and (3) any other property held by the partnership which, if held by the selling or distributee partner, would be considered property of the type described in (1) or (2).

Although the above definition makes no distinction in the term “inventory item” between a sale or redemption, Sec. 751(b)(3) states that in the case of a redemption only substantially appreciated inventory is considered a hot asset. In accordance with Regs. Sec. 1.751-1(d), inventory items are substantially appreciated if “the total fair market value of all inventory items of the partnership exceeds 120% of the aggregate adjusted basis for such property in the hands of the partnership.” Prior to June 8, 1997, the substantially appreciated test also applied to a sale or exchange. However, the 1997 Taxpayer Relief Act, P.L. 105-34, eliminated the requirement that inventory must be substantially appreciated to be classified as a hot asset in a transaction structured as a sale or exchange. Therefore, all items of inventory are considered hot assets in a disposition structured as a sale or exchange. In this regard a planning opportunity exists, as the application of Sec. 751 may ultimately generate an ordinary loss if the partnership holds inventory that has declined in value below its aggregate basis and the transaction is structured as a sale rather than a redemption.

Example 3: A disposes of his 50% interest in ABC. A’s proceeds on the disposition are $300,000 while his outside basis in the partnership interest is $90,000, resulting in an overall gain of $210,000. At the time of A’s departure, ABC has: (1) cash with a basis equal to FMV of $30,000; (2) inventory or property held for sale to customers with a basis of $50,000 and an FMV of $60,000; (3) realized accounts receivable with a basis of $100,000 and an FMV of $70,000; and (4) goodwill with a basis of zero and an FMV of $440,000.

As noted above, in accordance with Regs. Sec. 1.751-1(d)(2)(ii), the partnership’s inventory items include realized accounts receivable. Therefore, ABC’s accounts receivables must be aggregated with property held for sale to customers for the purpose of determining if the partnership’s inventory items are substantially appreciated. In this regard, inventory items are not substantially appreciated ($130,000 ÷ $150,000 = 86.67% < 120%) and are therefore not considered a hot asset. In the case of a redemption, the partnership is deemed not to have any unrealized receivables or substantially appreciated inventory, so A’s gain of $210,000 is classified as capital gain. However, if the disposition was structured as a sale of a partnership interest, A must account for all inventory items as a hot asset and will therefore recognize an ordinary loss of $10,000 [($150,000 – $130,000) × 50%] and a capital gain of $220,000.

Conclusion

Congress enacted Sec. 751 to prevent the conversion of potential ordinary income into capital gain upon the sale or redemption of a partnership interest. Given the federal rate differential between ordinary income rates (35%) and long-term capital gain rates (15%), a partner should consider the tax cost and purchase price allocation prior to finalizing an agreement to dispose of the partnership interest. As noted in Example 3, it is also important to consider the tax differences that may result between structuring a disposition as a sale or a redemption.